Thursday, January 06, 2011

Penny Stock Risk Premium Has Wrong Sign

In my book Finding Alpha I document 20 different asset classes where the risk premium is either missing or goes the wrong way. But I did not include penny stocks, so it's a good 'out of sample' test of my hypothesis, that he risk premium rises as one goes from super safe to safe, stays flat, then goes the wrong way for lottery ticket investments like sports betting, distressed debt, high volatility stocks, and of course lottery tickets.

In our nine year sample, approximately $820 Billion traded in the OTC markets. This represents less than a month of typical NYSE volume. Still, the OTC markets are not insignificant: the average stock in our sample lose about 15M dollars from the first observation to the last. In total, stocks in the OTC market lost approximately $180 Billion of market value over our sample period. These numbers themselves are conservative because we did not make any assumption about the value depreciation taking place for stocks that no longer trade.

In case you didn't know, penny stocks are lousy investments; high risk, negative return. They suggest either the Miller explanation, that differential expectations imply a winner's curse, or the Barberis and Huang explanation, that people really love positive skew. They leave with the note that they are looking at a model in which investors display risk aversion over losses and risk-loving behavior over large gains would conceivably explain the results.

That's the great thing about the 'risk premium'. It's not a theory, but rather a framework, so that any anomaly merely rejects an incorrect theory within this framework, and not the framework itself. Nonetheless, it is supposedly the foundation of modern finance, based on Markowitz's brilliant, and rigorous, insights. It explains everything, because when it doesn't, you just say people are not risk averse, but rather risk-loving over various parts of the return distribution for specific asset classes. Kahneman and Tversky's famous prospect theory argued that things like lotteries could be explained by 'risk-seeking behavior in losses involving moderate probabilities and of small probability gains', which of course is different. The Black Swan idea is that people prefer high probability bets with small gains but occasion high losses. The point is clear: the utility function explains residual returns, and places no restrictions on them.

Benchmarking, or a 'relative status' or 'envy' utility function, are all the same thing. It explains why risk premiums don't exist in general. It also explains the Easterlin Paradox, where greater wealth over time has neither reduced the risk free rate, nor increased general happiness. It explains too why people's asset allocations generally ignore strict mean-variance optimization, because they consider what the 'standard allocation' to be risk neutral, because keeping-up-with-the-Joneses is risk neutral. It's rather straightforward to increase one's Sharpe ratio (buy low volatility stocks), or one's covariance with their income (invest in other developed country indices), but this is considered risky, because then you have benchmark risk, which is what investors really hate more than volatility itself.

All the performance of penny stocks proves is that some investors are unsophisticated, and/or enjoy gambling. Certainly people are not buying penny stocks to keep up with other people, since the market weighting is tiny and they are not "investable" anyway.

You mention NYSE vs OTC. In the old days, people would call NASDAQ-listed stocks OTC, but now that it's an exchange the terminology is not 100% correct. I assume you mean the proper terminology, where by OTC you are including OTCBB ("Bullies"/OTC Bulletin Board) and Pink Sheets. Is that the set of stocks you're referring to by 'penny stocks'? If so, I'm surprised that their trading volume is 1/12 that of NYSE; that sounds too high. Can you please clarify?

Well, I just quoted the paper, which unfortunately combined ADRs with 'regular' penny stocks...the basic take-away, that penny stocks have negative returns, even accounting for risk factors such as the 3-factor FF model.

"Our study excludes trading in large multi-national firms like Nestle, whose stock trades in the OTC markets because Nestle chooses not to publish financial results conforming to US GAAP. We also exclude trading in securities that are issued by firms whose primary common shares trade on a regular exchange" (2-3).

Eric is right. People involved in the OTCBB and Pinksheets markets are largely engaging in quasi-gambling behaviour. Here are three points that stuck out:

"The average total return per stock (from the first to last price observation) is about -40%. The median total return is -97%. While 130 stocks have more than a ten-fold increase in value, this 1.8% of the sample is much too small to make up for all the stocks that become nearly worthless."

"Adjusted for the three Fama-French factors (market, size, book-to-market), the average alpha of OTC stocks is significantly negative. Nor does the bursting of the technology bubble in 2000 substantially explain the poor aggregate performance of OTC stocks."

"There is little difference between the average performances of delisted and never-listed stocks."

My comment must have gotten eaten up by the aether. I had two questions about the study:

1) Did the researchers include bankrupt companies in it? As you know, companies often trade on the Pink OTC Markets when they are in bankruptcy, and presumably including those stocks would lower average returns significantly.

2) How do you reconcile the findings of this study, with the findings of the study mentioned here that showed that stocks that have "no-trade days" (i.e., days when no shares in the stock were traded) outperform those that don't? Wouldn't no-trade day stocks primarily be penny stocks?